Setting the Record Straight on Kinder Morgan
publication date: Sep 17, 2015
author/source: Brian Nelson, CFA
Most, if not all, MLPs report distributable cash flow (DCF), which does not in the calculation consider growth capex, an important driver behind the generation of increased cash flow from operations in the future. When MLPs report distribution coverage ratios, this particular calculation also backs out growth capex from the equation, instead using only ‘sustaining capital expenditures.’
There are a number of contractual reasons why the data is presented in such a way, but from a valuation standpoint, we’ve always taken an issue with the MLP universe being implicitly valued on a future distributable cash flow stream that “covers” the distribution than on future free operating cash flow, which is a better measure of the free operating cash flow that a business generates.
The reason why free operating cash flow is more informative is quite straightforward. Distributable cash flow does not deduct the investment associated with driving future growth in an MLP’s cash flow from operations. Said differently, it’s like getting a free pass on all of the future growth spending that is required to drive incremental cash flow from operations, a severe imbalance in the valuation equation.
In valuing MLPs, we’ve circumvented the valuation imbalance by making the universal assumption that MLPs will continue to have access to the capital markets and that they will be able to issue equity and/or debt in such a way that is not value-destructive. Said differently, in our valuation models, we give MLPs credit for the future growth in cash flow from operations without deducting the growth capex that is required to drive it. We disclose this dynamic in every one of our 16-page reports within the MLP space.
-- 5 Reasons Why We Expect Kinder Morgan to Collapse, June 11, 2015
A performance track record is always evolving, and some of the best calls today may turn into some of the worst calls tomorrow. It happens all the time even with some of the best investors, and whether an idea is good or bad all depends on one’s time horizon, to a degree and in almost all cases.
First, we remain incredibly humble, understand that we could still be wrong, are grateful for a broad audience that appreciates our work, and we hope this article is not misconstrued as one in which “we’re patting ourselves on the back,” but instead, we hope it is viewed as one in where we’re setting the record straight. For those that may not be aware, we’ve subsequently moved to a “neutral” rating on Kinder Morgan following the collapse in its shares since early June.
In January of this year, Barron’s highlighted Valuentum as a “Survival Guide for Oil Investors.” It was quite the honor, and we have only increased our focus on giving energy investors and investors of all types access to the best insight, judgment, fair value estimates, and Valuentum Buying Index ratings on our website. In particular, the decision to remove Chevron (CVX) from the Valuentum Dividend Growth Newsletter portfolio at ~$102 per share on March 16, in our view, was a far better and more timely move in 2015 than the June 11 article on Kinder Morgan (KMI), where we outlined our views on the MLP arena (shown in italics above) in a piece that was picked up by Barron’s.
Chevron is now trading under $80 per share, and we think avoiding a 20% drop in shares on a $150+ billion energy equity is better than even a slightly larger decline on a company half its size. But the criticism for why we’ve been “wrong” on Kinder Morgan has been quite puzzling, especially since shares have fallen to $30 from $40 previously. “Bulls” of Kinder Morgan, for some time, have tried to convince investors that the third-largest energy company in North America is not leveraged to changes in energy resource pricing or to emerging economic weakness in China.
Yet now, to explain the sharp drop in shares, those same bulls will tell you that it has had everything to do with the fall in energy resource pricing and emerging economic weakness in China. We’re not sure they can have it both ways. We’d argue that Kinder Morgan’s shares have collapsed because they had been materially overpriced when they were trading north of $40 per share.
Fundamentally speaking, we continue to believe Kinder Morgan is levered to changes in energy resource pricing, and as its hedging portfolio rolls off in coming years, we’d expect its sensitivity to changes in crude oil and natural gas prices to increase by a multiple of 2015 levels and eventually challenge coverage ratios. Other midstream MLPs are not immune to changes in energy resource pricing and capital-market dependency either, and in our June 11 piece, we outlined our concerns of the entire MLP business model, as shown in the italics above.
Yet, Kinder Morgan “bulls” will continue to try to explain away Kinder Morgan’s weakness by comparing its performance to that of the Alerian MLP ETF (AMLP), as if 1) Kinder Morgan is an MLP (it is not) or 2) it is included in the ETF itself (it is not). What seems to have been lost on the critics of our work, however, but not on the market, is that our opinion of Kinder Morgan also mentioned our incredibly skeptical view of the sustainability of the MLP business model itself. That MLPs have also cratered since the time of the Kinder Morgan article is not inconsistent with our thesis.
In many ways, it is the same concerns that we have with Kinder Morgan as a corporate that we have with MLPs--most of them, if not all of them, are spending more in total capital spending and distributions than they generate in cash flow from operations. It is an unsustainable proposition over the long haul, in our view, and a condition that may come home to roost during a contractionary monetary environment or during adverse economic conditions that challenge the fluidity of the credit markets. The MLP business model may have to face both dynamics in coming years, and frankly it may not survive.
But let’s look at the numbers anyway. Kinder Morgan’s shares are trailing the Energy Select SPDR (XLE), of which it is a top 5 constituent, by more than 7 percentage points, since June 11—in just a few months. Kinder Morgan’s shares have collapsed nearly 25% since June 11 against a broader market decline of less than 5% since then--20 percentage points of alpha for broad-based portfolio managers. The median broker price target on Kinder Morgan was $45-$50 per share with nearly 80% of all analysts recommending the company as a “buy” and less than 5% a sell at the time of our piece. The latter is perhaps most compelling, even if 20 percentage points of alpha is not a head-turner.
Going against the market is never an easy task. In fact, it is an incredibly difficult one. But we always side with the investor in our conflict-free work, and we have an uncompromising focus on finding the right answer for investors. We continue to believe our call on Chevron has been a better one in 2015 than the Kinder Morgan one. Frankly, we could have done better with Kinder Morgan. For one, we could have highlighted our concerns when shares were trading north of $44 each, some 10% higher than we did. We acknowledge that there’s always room for improvement, and we’re always looking to get better.
Thank you for reading!